INTEREST RATES AND EXCHANGE RATES - WHAT IS THE RELATIONSHIP? pptx

The change from a negative correlation between interest rates and exchange rates in the 1970s to a positive correla- tion in the 1980s is due to changes in the relative importance of fa

Interest Rates and Exchange Rates— What is the Relationship?

By Craig S Hakkio

During much of the 1970s, U.S interest rates

and the foreign exchange value of the dollar

moved in opposite directions This relationship

was particularly pronounced from 1976 to 1979,

when short-term interest rates doubled, while the

trade-weighted value of the dollar fell 17 percent

In the 1980s, however, the relationship between

interest rates and the exchange rate appears to be

considerably different Indeed, for much of this

period, U.S interest rates and the value of the

dollar have been positively correlated

A key question is whether the apparent change

in the relationship between interest rates and ex-

change rates represents a significant structural

change in their linkages or whether the change

in the relationship can be explained by using stan-

dard economic models The answer to this ques-

tion has important implications for policymakers

Interest rates and exchange rates are crucial

elements in the transmission of monetary and

Craig S Hakkio is a senior economist at the Federal Reserve

Bank of Kansas City J Gregg Whittaker, assistant economist

at the bank, assisted in the preparation of the article

Economic Review ® November 1986

fiscal policy actions to economic activity If the channels through which policy actions affect the economy have been altered, policymakers may

find the design of policy to be more difficult and the consequences of policy actions more unpre- dictable Thus, models of interest rate and ex-

change rate linkages that worked well during the 1970s may not be appropriate in the 1980s This article argues that much of the apparent instability in the interest rate-exchange rate rela- tionship can be readily explained in terms of stan- dard economic models The change from a

negative correlation between interest rates and

exchange rates in the 1970s to a positive correla- tion in the 1980s is due to changes in the relative importance of factors underlying interest rate and exchange rate movements Thus, changes in inflation and expected inflation were the domi- nant influences causing high interest rates and a

lower dollar in the 1970s In the 1980s, in con-

trast, changes in real interest rates have been the dominant factor responsible for the positive cor- relation between interest rates and the dollar The article is divided into four sections The first section briefly reviews recent interest rate

33

and exchange rate movements The next section

discusses the fundamental determinants of interest

rates and exchange rates The third section

reviews the linkages between interest rates and

exchange rates and shows how they can be

positively or negatively correlated The final sec-

tion applies this analysis to interpreting the

behavior of interest rates and the dollar over the

1974-86 period

Interest rates and exchange rates:

the evidence since 1974

The changing relationship between interest rates

and the value of the dollar is illustrated in Chart

1 The interest rate used in this chart is the 10-year

constant maturity Treasury bond rate The

exchange rate is the effective exchange rate—a

weighted average of ten bilateral exchange rates

between the dollar and other major currencies

The data in the chart have been smoothed to

remove the influence of short-run factors and to

highlight basic trend behavior.!

As shown in Chart 1, interest rates and

exchange rates appear to have been negatively

correlated in the 1970s From 1975 to 1977, for

example, interest rates fell while the dollar rose

Then, from 1977 to 1980, while interest rates rose

sharply, the value of the dollar declined

' The exchange rate is the effective exchange rate—a weighted

average of ten bilateral exchange rates with Germany, Japan,

France, the United Kingdom, Canada, Italy, the Netherlands,

Belgium, Sweden, and Switzerland The long-term U.S interest

rate is the 10-year constant maturity U.S Treasury bond rate

The data in Charts 1-5 have been smoothed, to reduce the

influence of short-nun factors A six-month moving average was

used to smooth the data: if x, equals the original data, and s,

equals the smoothed data, then s, = (x; + %_4

+ + X_5)/6 The discussion in the text refers to the

smoothed data Sind not the original data Smoothing the data

usually causes the peaks and troughs to occur later than with

the original data In Chart 1, for example, the exchange rate peaks

in June 1985, but in the original data the peak occurs in February

1985 Using the 3-month CD rate produces a similar chart

The basic relationship between interest rates

and the dollar appears to have changed in the 1980s, however As the chart shows, during the

1980-81 period, interest rates and the dollar

moved in the same direction rather than in

opposite directions; interest rates and the dollar

trended upward, after abstracting from the sharp movement in interest rates in 1980 due to credit controls In 1982, however, the relationship reverted to the 1970s pattern, with a drop in interest rates associated with a rising dollar Then, from 1983 to 1986, a positive correlation reap- peared and interest rates and the dollar again moved up and down together

Chart 1 shows that there is no simple relation- ship between interest rates and the dollar This does not imply, however, that the relationship is

unstable or that the structure of the relationship broke down in the 1980s As argued in the fol- lowing sections, much of the behavior of interest rates and exchange rates over the 1974-86 period can be explained by the behavior of their under- lying determinants

Determinants of interest rates

and exchange rates The interest rate and exchange rate shown in Chart 1 are rates quoted in financial markets, that

is, they are nominal rates To understand their behavior over the 1974-86 period, it is useful to distinguish between real and nominal interest rates and between real and nominal exchange rates This section develops this distinction and iden- tifies common factors affecting interest rates and

exchange rates

Real and nominal interest rates The distinction between real and nominal interest rates has become familiar in analyses of

inflation during the 1970s While the nominal interest rate is the rate quoted by banks and the

CHART 1

U.S long-term interest rate and the exchange rate

160

120

Interest rate (right scale)

15

Exchange rate (left scale)

1974 '7§ 16 '77 T8 79 '80 "81 82 '83 '84 '85 '86

Source: Board of Governors of the Federal Reserve System

financial press, the real rate adjusts the nominal

rate for the influence of inflation According to

the *‘Fisher equation,’’ the nominal interest rate

i is equal to the real interest rate r plus the

expected rate of inflation p°:

(1) i=rt pe

Thus, for example, when a lender receives a 10

percent nominal interest rate but expected infla-

tion is 7 percent, the real interest rate is only 3

percent.? Although the lender receives 10 per-

cent more dollars, he can buy only 3 percent more

goods and services because inflation has increased

the price of goods and services

In this framework, nominal interest rates

? The tax deductibility of interest payments changes this state-

ment slightly, but the basic concepts are the same

Economic Review @ November 1986

change either because of a change in the under- lying real rate of interest or because of a change

in expected inflation For example, nominal interest rates could increase because of an increase

in the real rate, with no change in expected inflation Similarly, nominal interest rates could

decline because of a decline in inflationary

expectations, with no change in the real rate A number of factors can cause variation in the underlying real rate or expected rate of inflation The real rate of interest is determined by the demand for and supply of funds in the economy The supply of funds in the domestic economy comes from the saving of individuals and firms plus funds provided by the banking system The

demand for funds comes from firms making investment decisions, consumers borrowing in

excess of current income, and government finan- cing a budget deficit In an open economy, other

35

countries may provide an additional net demand

for or supply of funds

The real interest rate tends to rise or fall as the

demand for funds grows faster or slower than the

supply of funds The demand for funds increases,

for example, if the government borrows to finance

an increase in the deficit.? The government”s

increased demand for funds crowds out private

investors, driving up the real interest rate By pay-

ing a higher real interest rate, the government

ensures that it, rather than others, obtains the

funds it needs In this way, an increase in the

demand for funds puts upward pressure on the

real interest rate

Expectations of inflation can also change for

several reasons On the one hand, such special

factors as one-time changes in the price of energy

or food can have a temporary effect on the infla-

tion rate Since this shock may take several years

to work its way through the economy, expecta-

tions of inflation can be affected for some time

even though the shock has no permanent effect

on the inflation rate On the other hand, infla-

tion expectations can change because of events

leading to a continuously rising or falling price

level Such an effect might be associated with an

excessive or deficient rate of money growth

Real and nominal exchange rates

While the concept of the real interest rate has

been widely discussed in recent years, the con-

cept of a real exchange rate may be somewhat

less familiar As in the case of interest rates,

3 Some have argued that the federal budget deficit also leads to

an equal increase in the amount of savings, since individuals take

into account the future tax liabilities associated with the budget

deficit Others, however, believe that the supply of funds does

not increase equally, so that there is a net increase in the demand

for funds For a discussion of these arguments and a review of

the empirical evidence, see Charles Webster, ‘‘The Effects of

Deficits on Interest Rates,’' Economic Review, Federal Reserve

Bank of Kansas City, May 1983, pp 19-28

however, the distinction between a nominal exchange rate and a real exchange rate makes it

possible to distinguish real or relative price effects from changes in the general price level The nominal exchange rate quoted in the finan- cial press is the price of the dollar in terms of foreign currency For example, the exchange rate between the dollar and the Japanese yen might

be quoted as 160 yen per dollar In contrast, the real exchange rate is not a rate of currency exchange Rather, it is the relative price of U.S goods in terms of foreign goods As such, the real exchange rate reflects the underlying terms

of trade between U.S and foreign goods Equation 2 shows the relationship between the nominal exchange rate and the real exchange rate:

(2) e = q P*/P

In this equation, e is the nominal exchange rate,

q is the real exchange rate, P is the U.S price level, and P* is the foreign price level The nominal exchange rate, e, can be viewed either

as the price of the dollar in terms of foreign cur- rency or, equivalently, as the foreign price of U.S goods relative to the dollar price of U.S

goods.* In contrast, the real exchange rate, q, is

the price of U.S goods in terms of foreign goods Rearranging equation 2, it can be shown that the real exchange rate is simply the nominal exchange rate deflated by the ratio of foreign to domestic

prices (q = e/[P*/P])

From equation 2, it is clear that the nominal

exchange rate can change either because of a

change in the real exchange rate or because of

a change in the general price levels in the United States or abroad An increase in the real exchange

“For further elaboration on the determinants of the nominal

exchange rate, see Craig S Hakkio, ‘‘Exchange Rate Volatility and Federal Reserve Policy,’’ Economic Review, Federal Reserve Bank of Kansas City, July/August 1984, pp 18-31

rate or the foreign price level causes the nominal

exchange rate to appreciate, while an increase in

the domestic price level causes the nominal

exchange rate to depreciate

A variety of factors can cause the real exchange

rate to change For example, there may be a

change in tastes away from domestically produced

goods to foreign goods Suppose that Japanese

consumers decide to buy more U.S goods rather

than domestic products This shift in demand will

tend to raise the relative price of U.S goods,

leading to a rise in the real exchange rate Then,

if domestic and foreign price levels do not change,

the nominal exchange rate will also rise The

reason is that since Japanese consumers need

more dollars to purchase U.S products, they will

sell yen and buy dollars, causing the foreign

exchange value of the dollar to increase

Another reason for changes in real exchange

rates comes from international investment and

savings decisions In addition to buying U.S

goods, Japanese investors might buy U.S finan-

cial assets A decision to buy more U.S assets

could result from the view that the real return on

U.S assets exceeds the real return on comparable

Japanese assets If Japanese investors buy more

U.S assets, the real exchange rate will rise Since

this decision requires the purchase of additional

dollars in the foreign exchange market, the

nominal exchange rate will also appreciate

Changes in domestic and foreign price levels

are the second factor influencing nominal

exchange rates Equation 2 shows that exchange

rate movements are influenced by differences in

foreign and domestic price levels When prices

in the United States rise faster than prices abroad,

the nominal exchange rate depreciates because

foreigners reduce their purchases of more expen-

sive U.S goods and thus reduce their demand

for dollars in foreign exchange markets In con-

trast, when foreign prices rise faster than U.S

prices, the nominal exchange rate appreciates

because U.S citizens tend to import fewer of

Economic Review @ November 1986

the more expensive foreign goods As a result, the demand for foreign currencies falls and the foreign exchange value of the dollar rises The linkages between interest rates and exchange rates

The preceding section identified key factors underlying the behavior of nominal interest rates

and exchange rates This section examines the

channels linking interest rate and exchange rate movements and shows how changes in the relative importance of the underlying factors can result

in patterns of positive or negative correlation between interest rates and exchange rates

Inflation effects on interest rates and exchange rates

One simple channel linking interest rates and exchange rates is through the effects of inflation Since nominal interest rates depend on expected inflation while nominal exchange rates depend on relative rates of foreign and domestic inflation,

an inflation shock will affect both nominal interest rates and exchange rates

Inflation shocks can usually be expected to lead

to a negative correlation between nominal interest rates and exchange rates Suppose, for example, that an increase in the price of energy or faster money growth leads to an increase in U.S infla- tion To the extent that higher inflation is built into inflation expectations, nominal interest rates

in the United States will tend to rise And, if U.S

inflation exceeds foreign inflation, the nominal

exchange rate will tend to fall

Similarly, disinflationary policy could lead to

a negative relationship between interest rates and

exchange rates A reduction in U.S inflation that

led to lower inflation expectations would tend to reduce nominal interest rates in the United States

And, if the U.S inflation rate is lower than

foreign inflation rates, U.S products would

37

become more attractive in international markets

and the dollar would tend to appreciate

Real effects on interest rates

and exchange rates

Nominal interest rates and exchange rates are

also linked through movements in real interest

rates As discussion of the Fisher relationship

showed, changes in real interest rates are

translated directly into changes in nominal interest

rates In addition, changes in real interest rates,

by altering the relative attractiveness of domestic

and foreign investment opportunities, cause

movements in real and nominal exchange rates

To see the connection between real interest rates

and the exchange rate, consider a foreign investor

with a choice of investing in U.S or domestic

assets The choice depends partly on a comparison

of relative real interest rates But because assets

in different countries are denominated in different

currencies, changes in the real exchange rate also

affect the relative returns Any expected apprecia-

tion of the real value of the dollar represents an

expected capital gain and adds to the U.S real

return Likewise, any expected depreciation of

the real value of the dollar represents a capital

loss and lowers the U.S real return

Generally, market forces should equalize the

real returns to investment in the two countries

As a result, the real return to investment in the

United States—the U.S real interest rate plus the

expected appreciation of the real exchange rate—

should equal the foreign real interest rate:

(3) U.S real + expected = foreign real

interest appreciation interest

exchange rate That is, if the U.S real interest rate is higher than

the foreign real interest rate, the market must be

expecting the real exchange rate to depreciate

In this way, the expected depreciation of the real exchange rate offsets the higher U.S real interest rate and the total U.S real return equals the foreign real return Viewed differently, the expected appreciation or depreciation of the dollar

is directly related to the real interest rate differen- tial in the two countries

In this framework, an increase in the U.S real interest rate will lead to an increase in the real

exchange rate and the nominal exchange rate A higher U.S real interest rate increases the attrac- tiveness of U.S assets, leading to an increase in the demand for dollar-denominated assets and an appreciation of the real exchange rate Then, for

given price levels at home and abroad, the

nominal exchange rate also tends to rise

There is another way to see that an increase

in the U.S real interest rate leads to an increase

in the real exchange rate Because the total real return in the United States must equal the foreign real interest rate, as shown in equation 3, a rise

in the U.S real interest rate relative to the foreign real interest rate must lead to an expected

depreciation of the real exchange rate Therefore,

if the real exchange rate is assumed to be con- stant in the long run, the only way for the market

to expect the real exchange rate to depreciate in the future is for the real exchange rate to

appreciate today That is, an increase in the real interest rate leads to an increase in the current

real exchange rate and an expected depreciation

of the real exchange rate As William Branson put it, ‘“What must go down in the future [an expected depreciation], must go up today {the cur- rent real exchange rate].’’5

3 See William H Branson, *‘Causes of Appreciation and Volatil- ity of the Dollar,’’ The U.S Dollar—Recent Developments, Outlook, and Policy Options, proceedings of a conference spon-

sored by the Federal Reserve Bank of Kansas City, August 21-23,

1985, and Craig S Hakkio and J Gregg Whittaker, ‘‘The U.S Dollar—Recent Developments, Outlook, and Policy Options,"’ Economic Review, September/October 1985, Federal Reserve Bank of Kansas City, pp 3-15

Unlike inflation shocks, real interest rate shocks

can be expected to result in a positive correla-

tion between nominal interest rates and exchange

rates A rise in U.S real interest rates resulting

from higher budget deficits, for example, will

directly cause a rise in nominal interest rates In

addition, the higher real interest rate in the United

States will tend to raise both the real exchange

rate and the nominal exchange rate Similarly,

a reduction in real rates in the United States will

tend to lower nominal rates in the United States

directly And if the U.S real interest rate falls

relative to foreign real rates, there will be a cor-

responding fall in the real and nominal value of

the dollar

Interest rates and the exchange rate—

explaining the evidence

Chart 1 showed that the relationship between

nominal interest rates and the foreign exchange

value of the dollar appeared to change in the

1980s Interest rates and the exchange rate were

negatively related until 1980 For most of the

period since 1980, however, interest rates and

the dollar have tended to move in the same

direction

The preceding section presented a theoretical

framework in which inflation and real interest rate

shocks can cause different patterns in the interest

rate-exchange rate relationship This section

examines data on expected inflation, real interest

rates, inflation differentials, and real interest rate

differentials to see whether the theoretical frame-

work provides a consistent explanation of the

empirical evidence

Interest rates and exchange rates:

1974 to 1979

According to the analysis presented in this

article, the negative relationship between interest

rates and the exchange rate during the 1970s,

Economic Review @ November 1986

shown in Chart 1, is consistent with the view that

inflation shocks dominated interest rate and exchange rate movements Casual evidence sup- ports this view Oil and food prices increased dra- matically in the early 1970s After rising only 5 percent in 1972, food prices increased at an annual rate of 15 percent during the first three quarters of 1973 Then, as a result of OPEC, retail energy prices jumped 44 percent from the end of 1973 to the middle of 1974, after rising only 8 percent in the three previous quarters Inflation rose again in the late 1970s, as food price

increases in 1977-79 and oil price increases in

1978-79 occurred during a period of rapid growth

in the money supply

More direct evidence in support of an inflation explanation of interest rate and exchange rate movements can be obtained by looking at their underlying determinants To the extent that inflation in the United States is built into infla- tion expectations, nominal interest rates will tend

to rise and fall with inflation expectations Thus,

a high positive correlation between nominal interest rates and expected inflation supports the view that real factors were not an important deter-

minant of nominal interest rate changes If, in

addition, there is a strong negative correlation

between the dollar and the inflation differential

in the United States and abroad, this supports an inflation explanation for exchange rate move- ments rather than a real explanation

Chart 2, which plots the U.S 3-month CD interest rate and a measure of expected inflation,

shows that interest rates and expected inflation

moved together from January 1974 to December 1979.6 Both rose in the first three quarters of

1974, fell through the first quarter of 1977, and

rose again until the end of 1979 Given the close

~

6 The Board of Governors of the Federal Reserve System reports

a real interest rate that is comparable with the 3-month CD interest rate The expected rate of U.S inflation is defined as the CD

interest rate minus the real interest rate

39

CHART 2

U.S interest rates and expected inflation

Percent

Expected inflation

Short-term interest rate

|

CHART 3

Exchange rate and inflation differential

105†—

Exchange rate

95

Inflation differential

Source: Board of Governors of the Federal Reserve System

movement of nominal interest rates and expected

inflation during this period, most of the changes

in the nominal interest rate appear to be due to

changes in expected inflation rather than to

changes in real interest rates

Chart 3, which plots the nominal exchange rate

and the difference in U.S and foreign inflation,

supports the inflation explanation of exchange rate

movements for the period from January 1974 to

December 1979.7 During the 1974-79 period, the

nominal exchange rate and the inflation differen-

tial moved in opposite directions and were highly

correlated In 1975 and 1976, the inflation dif-

ferential fell as foreign inflation exceeded U.S

inflation During this period the dollar rose Then,

from 1977 to 1979, the inflation differential rose

as U.S inflation exceeded foreign inflation and

the dollar fell Thus, inflation factors appear to

have dominated real factors in explaining

exchange rate movements during this period

Interest rates and exchange rates:

1980 to 1986

Nominal interest rates and the dollar have been

positively correlated during much of the 1980s,

as shown in Chart 1 Such a relationship is con-

sistent with the dominance of real rather than

inflationary shocks to the economy At first

glance, this dominance might seem puzzling

After all, the 1980s have generally been a period

of disinflation, with inflation declining from

double-digit rates in the late 1970s to the 3 to 4

percent range in the mid-1980s

Real factors have been important, however

Real interest rates have been significantly higher

7 The Board of Governors reports a foreign weighted average

CPI The foreign rate of inflation equals the percentage change

in the foreign weighted average CPI; the U.S rate of inflation

equals the percentage change in the U.S CPI; the inflation dif-

ferential equals the U.S rate of inflation minus the foreign rate

of inflation (and is a 12-month moving average)

Economic Review @ November 1986

in the 1980s than at any other time in the postwar

period The rise in real rates has been attributed

to a number of factors: restrictive monetary policy

in the 1980-82 period, major changes in tax laws affecting investment spending, an apparent decline in the personal savings rate, and record federal budget deficits.®

Again, evidence in support of a real explana- tion of interest rate and exchange rate movements during the 1980s can be obtained by looking at

their underlying determinants If real factors are

important in explaining nominal interest rate movements, real interest rates should have a significant positive correlation with nominal interest rates Similarly, if real factors are of primary importance in explaining exchange rate

movements, there should be a strong positive cor- relation between the nominal exchange rate and

the difference between real interest rates in the

United States and abroad

Chart 4, by plotting the real and nominal 10-year constant maturity bond rate from January

1980 to December 1985, shows that there is a

clear positive relationship between nominal and real interest rates over this period.? Moreover, since expected inflation declined during most of this period, nominal interest rates should have declined if inflationary factors were dominant Movements in the nominal exchange rate and

the real interest rate differential, as shown in

Chart 5, also tend to support the real explana- tion of exchange rate movements From 1980 to

mid- 1982, the real interest rate differential rose

§ See Stephen Cecchetti, ‘‘High Real Interest Rates: Can They

Be Explained?”’ Economic Review, Federal Reserve Bank of Kan- sas City, September/October 1986, for a discussion of the deter- minants of real interest rates and an analysis of recent movements

in U.S real interest rates

° The Board of Governors of the Federal Reserve System reports

a long-term U.S and foreign real interest rate The foreign real interest rate is a weighted average of ten corresponding foreign

rates

41

CHART 4

U.S real and nominal interest rates

Percent

16

Nominal interest rate

Real interest rate

1980 1981 1982 1983 1984 1985 1986 CHART 5

The exchange rate and real interest rate differential

Real interest rate differential ¬ 12

¬ 8

120 [

44 Exchange rate

¬ 0

1980 1981 1982 1983 1984 1985 1986

Source: Board of Governors of the Federal Reserve System